The real problems with private equity

The latest mooted private equity deal - a $45bn buyout of Texas power group TXU by Kohlberg Kravis Roberts and Texas Pacific - could set a new record for the biggest ever deal. But in the UK, the industry was in no mood to celebrate. Damon Buffini, head of Europe's biggest private-equity house, Permira, has had to break cover to defend it from charges that it represents "the ugly face of capitalism".

Behind the name-calling lie two persistent accusations: private equity axes jobs and lacks transparency, said Tony Jackson in the FT. The first doesn't really stand up; necessary job cuts help productivity and growth, while cutting real jobs damages assets and makes fundraising harder. Greater disclosure would be nice, but private equity is still bound by the same requirements as other private firms.

But there's a more serious concern: does private equity actually add value? Edward Hadas on Breakingviews says that "academic research has repeatedly demonstrated that the high returns from buyouts derive solely from their use of leverage". And a recent Morgan Stanley report, Selling the Family Silver', warns investors to be wary of firms returning to market after being taken private. Author Graham Secker said, "these deals are a value grab that eats into future earnings. They have to be paid for later." Selling off assets and leasing them back works in boom times, but leaves firms exposed in a downturn. "Cash flow will drop in a recession, but they still have to pay out charges on their rental and operating leases that's when the big squeeze hits."

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On top of this, adds Jackson, while it has been possible for private equity to load a firm with "excess debt, then strip the cash out as a dividend", allowing it to profit even if the firm goes bust, there has been a safeguard banks "would not lend more than a company could bear". This has changed with the advent of credit derivatives and spreading of risk. It's a "natural enough development and not obviously harmful", except that the credit derivatives market "seems to have taken leave of its senses". The result? Private-equity houses can now overload firms with debt, because "those underwriting the risk are quite insensitive to the danger this poses". Once the music stops "a lot of people will get burnt".

And for MoneyWeek columnist Simon Nixon's views on the matter, read: Rise of private equity a case for celebration, not condemnation